Covered Bonds vs. ABS: Is This a Valid Rivalry?

Although covered bonds and ABS are starting to be regarded as alternatives to one another, market experts said that these two markets could definitely co-exist. For one, these products have very different sets of buyers. The two also have varying liquidity and structural advantages and constraints.

Rick Watson, managing director of theAssociation for Financial Markets in Europe/European Securitization Forum,said that the covered bond and the securitization markets have two very distinct investor bases.

Those who buy covered bonds areinterested in interest rate products. These investors are looking for "a higher-yielding alternative to government bonds. Their main objective is liquidity -to be able tosell quicklyif needed, and not necessarilyneed to do an extensive amount of credit analysis," Watson said.

On the other hand, securitization, according to Watson, is viewed as a credit product where some markets are more liquid than others. "For some credit investors, liquidity wasless of a concern than relative value on the assumption that there was at least some liquidity in the product," he said. "That has not really changed."

However, he added that the crisis demonstrated thatmany ofthe securitizationsthatinvestors thought wereliquid, were actually not.Many investors assumed that the triple-A ratings on these securitiesimpliedthat these securities were liquid.

Other differences include the fact that covered bonds are bank debt that take up bank line capacity from an investor standpoint. A counterparty, therefore, would have restrictions on its lending lines andinvestors' capacity to purchase covered bonds issomewhat limited because of this.

Securitizations are not subject to thesesame bank line counterpartyrestrictions as long as they are not structured where the issuerguaranteesthe whole deal, Watson explained.

"Although credit investors will still havecounterparty restrictions on asset poolsand possibly servicers, theseare generally different than bank counterparty restrictions," he said. "Thereare other technical considerations for issuers that may limit the amount of covered bond funding they want to issue."

Since they are backed by specific cash flows and are not corporate debt obligations,securitizationswill inevitablyinvolve a structure, which typically requires awider spread from investors. Covered bonds, on the other hand, have very simple structures, causing them to price at tighter spreads.

Additionally, Watson saidsecuritizations have an important potential benefit to issuers. "If you sell enough of the risk, a transfer of economic risk occurs and regulatory capital charges are reduced," Watson said."In addition, if substantially all of the risk is transferred, then the issuercouldget accounting sales treatment if the the criteria is satisfied, which is important given that this is one of few ways to fund without increasing leverage in this constrained environment," Watson said.

In Europe, Watson explained that, "banks haveongoing funding needsand the question is whether they have enough cash to refinance maturing deals. Securitization can play an important role in raising this funding, irrespective of regulatory or accounting aspects."

He added that there is no specific leverage capat the present,butmany banks are actively managing, andtypically reducing their leverage for other reasons, which could then have an impact on lending to the economy.

Investor Base

In terms of tapping a new investor base, Tim Skeet, head of covered bonds for Bank of America Merrill Lynch, said that from the European perspective, the U.S. presents an incremental increase in investor demand for the product that could be uncovered.

"The U.S. is a vast source of liquidity with it having sophisticated investors prepared to do their home work," Skeet said. Covered bonds, he said, would be a good-quality source of funds for different types of accounts.

"Non-U.S. banks tapping the U.S. investor base - that whole process has swung into motion, and I think both investors and issuers find the story quite compelling," he added.

Developing the covered bond appetite in the U.S. might also fill the need for high-quality rate products that the GSEs were serving and would be able to fill the void left by the drying up of the guaranteed market, Skeet said.

Another underlying question is whether those that are diversifying out of the covered bond market will turn to securitization.

Riccardo Fanelli, who is a director in fixed-income structured finance at the Royal Bank of Scotland (RBS), said that covered bond investors are probably not going to make the switch. Some ex-ABS investors are now buying covered bonds, but they remain a minority.

"However, it's more about the fact that issuers who are moving out of ABS and are starting to look at covered bonds are now realizing that the market is not necessarily available to them and it's not as deep as they thought," Fanelli said. The lack of accessibility to the market is especially true for small issuers and those in markets that don't have a strong domestic bid, he added.

He also said that credit risk is not necessarily the main driver for investors' negative view of ABS in Europe. "In fact, the performance of ABS - with a few exceptions like U.K. nonconforming RMBS and CMBS - has proven to be very strong," he said.

The problems, he explained, are more MTM volatility - which is currently much lower - the lack of liquidity and the general negative perception of ABS globally.

"That said, spreads are now attractive for investors and not unreasonable for issuers and volatility has calmed down," he stated. He added that these factors will be positive for a securitization market revival.

He noted, however, that an important negative factor for issuers and investors is BASEL III. It still remains to be seen, he said, how the positives and the negatives will eventually play out.

Tiering in Covered Bonds

Although covered bonds have remained the funding choice for European banks since the ABS market closed down, the impact of the sovereign crisis is starting to show its face with the tiering between issuers in different countries, according to a presentation by Fanelli at the Global ABS 2010 conference held in London in June.

"This is undermining the possibility for some banks to issue covered bonds, especially newcomers when the domestic market doesn't provide support," he said at this presentation, adding that this has caused several issuers in some countries to consider the ABS market again.

Indeed, the sovereign crisis that started with Greece, has negatively impacted some parts of the covered bond market.

However, BofA Merrill's Skeet said the sovereign crisis has moved Europe away from a heterogeneous market and toward a greater recognition of differences in covered bond products and jurisdictions. "It's difficult for institutions to completely separate from the sovereign risk, and investors are now pricing for differentiation even within jurisdictions," he said.

Jose Sarafana, head of covered bond strategy at Societe Generale Corporate & Investment Banking, said that high sovereign volatility makes issuing in the covered bond market very difficult, as shown by the almost non-existent issuance in May. He added that the composition of issuance has also changed. Covered bond issuers that are under stable sovereign markets have had a much easier time issuing and have also been able to increase their share of total issuance.

He added that if the current turmoil continues, banks will be under pressure to use the covered bond market since senior unsecured bank bonds are now hard to sell.

This puts in to question the fate of countries that are caught up in the sovereign crisis. "Government-guaranteed bonds are no solution," Sarafana wrote, "as investors often do not want to invest in any kind of assets linked to certain nations."

For instance, he said that there have been no attempts to issue government-guaranteed bonds out of Greece considering that sovereign bonds are in trouble. The solution for issuers in Greece has been to set up covered bond programs that are entirely sold or lent for repo to the European Central Bank (ECB).

Last Thursday, published reports said that covered bond issuance had been strong in the previous five trading days as banks were scrambling to take advantage of the final days of the ECB's purchase program.

The program ends in the middle of this week, so now the question becomes what happens to the covered bond platforms that rely on ECB support.

Skeet said that last year saw the beginning signs of recovery for the sector, specifically in the French and German markets. The investor base in these countries are the, "core axis of the market," he said.

But then the ECB announced its covered bond purchase program in May 2009, and this had the effect of "turbo charging and broadening the market's recovery" to include jurisdictions and regions that did not have access to the market beforehand. "It's a strongly successful program that achieved a lot," he added.

According to Sarafana, central bank support for the market will not be taken away entirely just because of the orms that rely on ECB support.

Sarafana cited the fact that the ECB's bond purchasing plan is not just for government bonds, and could easily be extended to include covered bonds. "It would make no sense politically for the European authorities to let the covered bond market go under after supporting it for year," Sarafana wrote.

This might be why there are still new issuers from Greece and Italy accessing the market. France and the U.K. are also seeing new entrants into the covered bond arena.

In terms of supply, RBS estimated that this year's euro benchmark covered bond supply will total and the U.K. are also seeing new entrants into the covered bond arena.

A supply driver, according to Fanelli's presentation, is the ongoing geographic expansion of the covered bond markets and the ever-growing number of issuers.

For instance, according to Luca Bertalot, head of the European Covered Bond Council, out of the 27 members of the European Union (EU) only four do not have covered bond legislation. Two of the four, Belgium and Cyprus, are waiting for their respective covered bond legislation to be finalized within the next year or so, leaving Estonia and Malta as the only nations within the EU without such a legislation either existing or being worked on. Outside the EU, Ukraine, Norway and Switzerland have existing legislation for the sector. Meanwhile, Russia is trying to finalize its covered bond legislation and Turkey has one in place.

The U.S. (please see sidebar), Canada, Mexico, Australia, and New Zealand are in the process of either preparing or contemplating the introduction of covered bond legislation.

Rating Agency Perspective

Also at the Global ABS conference, panelist Vanessa Purwin, who is a director in covered bonds at Fitch Ratings, spoke about the effects of the current problems in Greece on covered bond ratings. She also explained the differences in rating RMBS versus covered bond collateral.

Purwin said that the senior tranches on Fitch-rated Greek RMBS are currently rated higher than the country's covered bonds despite both being subject to a six notch cap above the sovereign rating.

Currently, Purwin said, there are three Fitch-rated Greek covered bond programs, two that are at 'A+' and another one at 'A-.'

"There's potential for the enhancement to be higher in size to account for the market value risk that you don't have in RMBS," Purwin said. She added, however, that - provided other conditions are met - with higher over collateralization levels, covered bond programs can still be rated triple-A.

Additionally, Purwin said that,"the asset-liability mismatch is generally not present in the RMBS market given their passthrough structures as it is for covered bonds."

However, there are some programs where the mismatch is not as large, as is generally the case for long-standing programs with multiples issues outstanding like those seen in Germany.

Purwin added that Fitch looks at the Issuer Default Rating as part of the rating agency's analysis to determine the financial soundness of the covered bond issuer.

But, Alessandro Settepani, a senior director at Fitch, said that covered bonds are often rated higher than the banks that issue them, so deals are expected to perform despite a default by the bank.

Covered Bonds Advance in Reform Bill

As of Wednesday, House and Senate conferees shaping the final regulatory reform bill tentatively accepted an amendment by Rep. Scott Garrett, R-N.J. that would create a new legal and regulatory framework for the development of a covered bond market in the U.S., according to a report by National Mortgage News, an ASR sister publication.

In Europe, where the issuance of mortgage-backed covered bonds is more common, banks service and keep the mortgages on their books in a manner unlike the MBS used in the U.S., where underlying mortgages are traditionally placed in separate, off-balance-sheet trusts.

"Covered bond legislation offers a way for the government to provide some certainty for private enterprises to find a way to generate liquidity through innovation of a new marketplace," Garrett said.

The New Jersey congressman also stressed that covered bonds would open the door for lenders to originate mortgages that are not government-guaranteed .

Under the amendment, the Treasury Department would be the primary regulator of covered bonds and would set standards and reporting requirements for issuers.

House Financial Services Committee chairman Barney Frank, D-Mass., said the conferees would not formally approve the Garrett amendment until Thursday, giving regulators time to refine their concerns and "tell us what they are," Frank said.

Sen. Bob Corker, R-Tenn., was prepared to offer a similar covered bond amendment on the Senate side, but House members offered their amendments to the regulatory reform bill first.

Tom Deutsch, executive director of the American Securitization Forum (ASF), issued a statement of support for House-drafted covered bond legislation currently being considered by the House-Senate conference committee on financial reform.

"We urge policymakers and Senate conferees to seriously consider and accept the House offer on covered bonds," Deutsch said.

He added the proposal would facilitate a "robust covered bond market as it includes important provisions for default and insolvency of covered bond issuers and subjects covered bonds to appropriate securities regulation by federal regulators."

- Matthew Silfee

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